Financial Management

Prepared & Presented by

Dr. S. Thameemul Ansari
Assistant Professor & Research Supervisor
PG and Research Department of Commerce
Islamiah College (Autonomous)
New Town, Vaniyambadi – 635 752
 Financial Management: Meaning and Definition
Financial Management means planning, organizing, directing and controlling the
financial activities such as procurement and utilization of funds of the enterprise. It means
applying general management principles to financial resources of the enterprise.

Financial Management is a regular practice in a business environment. It involves

managing a company’s financial resources to ensure there is little or no wastage.

It controls every single thing regarding the company’s financial activities which includes
the procurement of funds, use of funds, payments, accounting, risk assessment, and other things
that are related to finances.
 Definition of FM
The most popular and acceptable definition of financial management as given by
1. S.C.Kushal is that “Financial Management deals with procurement of funds and their
effective utilization in the business”.
2. Weston and Brigham: Financial Management “is an area of financial decision-
making, harmonizing individual motives and enterprise goals”.
3. Joseph and Massie: Financial Management “is the operational activity of a business that is
responsible for obtaining and effectively utilizing the funds necessary for efficient operations”.
4. Massie: “Financial management is the operational activity of a business that is responsible for
obtaining and effectively utilizing the funds necessary for efficient operations”.
 Scope of FM

1. Investment Decisions: Managers need to decide on the amount of investment available out of the existing finance, on a long-term
and short-term basis. They are of two types:

• Long-term investment decisions or Capital Budgeting mean committing funds for a long period of time like fixed assets. These
decisions are irreversible and usually include the ones pertaining to investing in a building and/or land, acquiring new
plants/machinery or replacing the old ones, etc. These decisions determine the financial pursuits and performance of a business.

• Short-term investment decisions or Working Capital Management means committing funds for a short period of time like
current assets. These involve decisions pertaining to the investment of funds in the inventory, cash, bank deposits, and other
short-term investments. They directly affect the liquidity and performance of the business.
 Contd.
2. Financing Decisions: Managers also make decisions pertaining to raising finance from long-term sources (called
Capital Structure) and short-term sources (called Working Capital). They are of two types:
• Financial Planning decisions which relate to estimating the sources and application of funds. It means pre-
estimating financial needs of an organization to ensure the availability of adequate finance. The primary objective of
financial planning is to plan and ensure that the funds are available as and when required.
• Capital Structure decisions which involve identifying sources of funds. They also involve decisions with respect to
choosing external sources like issuing shares, bonds, borrowing from banks or internal sources like retained earnings
for raising funds.
3. Dividend Decisions: These involve decisions related to the portion of profits that will be distributed as dividend.
Shareholders always demand a higher dividend, while the management would want to retain profits for business needs.
Hence, this is a complex managerial decision.
 Objectives of FM
• To ensure availability of sufficient funds at reasonable cost (liquidity).

• To ensure effective utilization of funds (financial control).

• To ensure safety of funds by creating reserves, re-investing profits, etc. (minimization of risk).

• To ensure adequate return on investment (profitability).

• To generate and build-up surplus for expansion and growth (growth).

• To minimize cost of capital by developing a sound and economical combination of corporate

securities (economy).

• To coordinate the activities of the finance department with the activities of other departments of the
firm (cooperation).
 Profit Maximisation
Very often maximization of profits is considered to be the main objective of
financial management. Profitability is an operational concept that signifies economic
efficiency. Some writers on finance believe that it leads to efficient allocation of
resources and optimum use of capital.

It is said that profit maximization is a simple and straightforward objective. It also

ensures the survival and growth of a business firm. But modern authors on financial
management have criticized the goal of profit maximization.
 Wealth Maximisation
Prof. Ezra Solomon has advocated wealth maximization as the goal of financial decision-
making. Wealth maximization or net present worth maximization is defined as follows: “The gross
present worth of a course of action is equal to the capitalized value of the flow of future expected
benefits, discounted (or as capitalized) at a rate which reflects their certainty or uncertainty.

Wealth or net present worth is the difference between gross present worth and the amount of
capital investment required to achieve the benefits being discussed. Any financial action which creates
wealth or which has a net present worth above zero is a desirable one and should be undertaken.
 Functions and Role of Financial Manager
1. Estimating the Amount of Capital Required: This is the foremost function of the financial manager. Business firms require capital for:

(i) purchase of fixed assets,

(ii) meeting working capital requirements, and

(iii) modernisation and expansion of business.

2. Determining Capital Structure: Once the requirement of capital funds has been determined, a decision regarding the kind and

proportion of various sources of funds has to be taken. For this, financial manager has to determine the proper mix of equity and debt and

short-term and long-term debt ratio. This is done to achieve minimum cost of capital and maximise shareholders wealth.

3. Choice of Sources of Funds: Before the actual procurement of funds, the finance manager has to decide the sources from which the

funds are to be raised. The management can raise finance from various sources like equity shareholders, preference shareholders,

debenture- holders, banks and other financial institutions, public deposits, etc.
 Contd.
4. Procurement of Funds: The financial manager takes steps to procure the funds required for the business. It might require negotiation with creditors and
financial institutions, issue of prospectus, etc. The procurement of funds is dependent not only upon cost of raising funds but also on other factors like
general market conditions, choice of investors, government policy, etc.

5. Utilisation of Funds: The funds procured by the financial manager are to be prudently invested in various assets so as to maximise the return on
investment: While taking investment decisions, management should be guided by three important principles, viz., safety, profitability, and liquidity.

6. Disposal of Profits or Surplus: The financial manager has to decide how much to retain for ploughing back and how much to distribute as dividend to
shareholders out of the profits of the company. The factors which influence these decisions include the trend of earnings of the company, the trend of the
market price of its shares, the requirements of funds for self- financing the future programmes and so on.

7. Management of Cash:Management of cash and other current assets is an important task of financial manager. It involves forecasting the cash inflows
and outflows to ensure that there is neither shortage nor surplus of cash with the firm. Sufficient funds must be available for purchase of materials, payment
of wages and meeting day-to-day expenses.

8. Financial Control:Evaluation of financial performance is also an important function of financial manager. The overall measure of evaluation is Return
on Investment (ROI). The other techniques of financial control and evaluation include budgetary control, cost control, internal audit, break-even analysis
and ratio analysis. The financial manager must lay emphasis on financial planning as well.
 Sources of Finance
1. Long-Term Sources of Finance: Long-term financing means capital requirements for a period of more than 5 years to 10, 15, 20 years or maybe

more depending on other factors. Capital expenditures in fixed assets like plant and machinery, land and building, etc of business are funded using

long-term sources of finance. Part of working capital which permanently stays with the business is also financed with long-term sources of funds.

Long-term financing sources can be in the form of any of them:

• Share Capital or Equity Shares

• Preference Capital or Preference Shares

• Retained Earnings or Internal Accruals

• Debenture / Bonds

• Term Loans from Financial Institutes, Government, and Commercial Banks

• Venture Funding

• Asset Securitization

• International Financing by way of Euro Issue, Foreign Currency Loans, ADR, GDR, etc.
 Contd.
2. Medium Term Sources of Finance: Medium term financing means financing for a period of 3 to 5 years and is used generally for
two reasons. One, when long-term capital is not available for the time being and second when deferred revenue expenditures like
advertisements are made which are to be written off over a period of 3 to 5 years. Medium term financing sources can in the form of
one of them:

• Preference Capital or Preference Shares

• Debenture / Bonds

• Medium Term Loans from

• Financial Institutes

• Government, and

• Commercial Banks

• Lease Finance

• Hire Purchase Finance

 Contd.
3. Short Term Sources of Finance: Short term financing means financing for a period of less than 1 year. The need for short-term
finance arises to finance the current assets of a business like an inventory of raw material and finished goods, debtors, minimum cash
and bank balance etc. Short-term financing is also named as working capital financing. Short term finances are available in the form
of:

• Trade Credit

• Short Term Loans like Working Capital Loans from Commercial Banks

• Fixed Deposits for a period of 1 year or less

• Advances received from customers

• Creditors

• Payables

• Factoring Services

• Bill Discounting etc.

 CAPITAL BUDGETING: Meaning & Objectives
Capital Budgeting is the process of making investment decision in fixed assets or capital
expenditure. Capital Budgeting is also known as investment, decision making, planning of capital
acquisition, planning and analysis of capital expenditure etc.
• To find out the profitable capital expenditure.
• To know whether the replacement of any existing fixed assets gives more return than earlier.
• To decide whether a specified project is to be selected or not.
• To find out the quantum of finance required for the capital expenditure.
• To assess the various sources of finance for capital expenditure.
• To evaluate the merits of each proposal to decide which project is best.
 Features of Capital Budgeting
• Capital budgeting involves the investment of funds currently for getting benefits in the future.

• Generally, the future benefits are spread over several years.

• The long term investment is fixed.

• The investments made in the project is determining the financial condition of business organization in
future.

• Each project involves huge amount of funds.

• Capital expenditure decisions are irreversible.

• The profitability of the business concern is based on the quantum of investments made in the project.
 CAPITAL BUDGETING: Process
1. Identifying investment opportunities: An organization needs to first identify an investment opportunity. An investment opportunity can be anything
from a new business line to product expansion to purchasing a new asset. For example, a company finds two new products that they can add to their
product line.
2. Evaluating investment proposals: Once an investment opportunity has been recognized an organization needs to evaluate its options for investment.
That is to say, once it is decided that new product/products should be added to the product line, the next step would be deciding on how to acquire these
products. There might be multiple ways of acquiring them. Some of these products could be:
a) Manufactured In-house
b) Manufactured by Outsourcing manufacturing the process, or
c) Purchased from the market
3. Choosing a profitable investment: Once the investment opportunities are identified and all proposals are evaluated an organization needs to decide the
most profitable investment and select it. While selecting a particular project an organization may have to use the technique of capital rationing to rank the
projects as per returns and select the best option available.
In our example, the company here has to decide what is more profitable for them. Manufacturing or purchasing one or both of the products or scrapping the
idea of acquiring both.
4. Capital Budgeting and Apportionment: After the project is selected an organization needs to fund this project. To fund the project it needs to identify
the sources of funds and allocate it accordingly. The sources of these funds could be reserves, investments, loans or any other available channel.
5. Performance Review: The last step in the process of capital budgeting is reviewing the investment. Initially, the organization had selected a particular
investment for a predicted return. So now, they will compare the investments expected performance to the actual performance.
In our example, when the screening for the most profitable investment happened, an expected return would have been worked out. Once the investment is
made, the products are released in the market, the profits earned from its sales should be compared to the set expected returns. This will help in the
performance review.
 Pay Back Period
In this technique, the entity calculates the time period required to earn the
initial investment of the project or investment. The project or investment
with the shortest duration is opted for.
Payback period is the time required to recover the initial cost of an
investment. It is the number of years it would take to get back the initial
investment made for a project. Therefore, as a technique of capital
budgeting, the payback period will be used to compare projects and derive
the number of years it takes to get back the initial investment. The project
with the least number of years usually is selected.
Problems related to Pay Back Period
Problems related to PBP
Solution to the above problem
Problems related to PBP
Solution to the above problem
 Accounting Rate of Return
Accounting Rate of Return (ARR), also popularly known as the average
rate of return measures the expected profitability from any capital investment.
ARR indicates the profitability from investments using simple estimates
which helps in evaluating capital projects. This method divides the net income
from an investment by the total amount invested in obtaining the ARR.
Problems related to ARR
Solution to the above problem
 Net Present Value and Profitability Index
Net present value is one of many capital budgeting methods used to evaluate potential
physical asset projects in which a company might want to invest. Usually, these capital investment
projects are large in terms of scope and money, such as purchasing an expensive set of assembly-
line equipment or constructing a new building.
Net present value uses discounted cash flows in the analysis, which makes the net present
value more precise than of any of the capital budgeting methods as it considers both the risk and
time variables.
Profitability Index is the ratio of the present value of future cash flows of the project to the
initial investment required for the project.
Problems related to NPV
Contd.
 Cost of Capital: Introduction
The cost of capital is the cost of a firm's debt and equity funds, or the required rate of
return on a portfolio of the company's existing securities. It is used to evaluate and decide
new projects, as well as the minimum return investors expect from the invested capital.
The cost of capital may be computed using debt, equity, and weighted average
formulas and is useful in making capital budgeting decisions. A proposal is not accepted if
its rate of return is less than the cost of capital. Financial performance and investment
acceptability may be determined from analyzing the discounted cash flows. cost of capital is
simply the cost which is paid for using the capital.
 Components of Cost of Capital
1. Cost of Debt Capital: Generally, cost of debt capital refers to the total cost or the rate of interest paid by an
organization in raising debt capital. However, in a real situation, total interest paid for raising debt capital is not
considered as cost of debt because the total interest is treated as an expense and deducted from tax. This reduces the tax
liability of an organization.

• Computation of Cost of Redeemable Debt

• Computation of Cost of Irredeemable Debt

2. Cost of Preference Share Capital: Cost of preference capital is the sum of amount of dividend paid and expenses
incurred for raising preference shares. The dividend paid on preference shares is not deducted from tax, as dividend is an
appropriation of profit and not considered as an expense.

• Computation of Cost of Redeemable Preference Share Capital

• Computation of Cost of Irredeemable Preference Share Capital

 Contd.
3. Cost of Equity Capital: It is very difficult to calculate the cost of equity capital as compared to debt capital and preference capital.
The main reason is that the equity shareholders do not receive fixed interest or dividend. The dividend on equity shares varies
depending upon the profit earned by an organization. Risk factor also plays an important role in deciding rate of dividend to be paid
on equity capital. Therefore, there are various approaches to calculate cost of equity capital.

• Dividend Price Approach

• Dividend Price Plus Growth Approach

• Earnings Price Ratio Approach

• Capital Asset Price Model (CAPM)

• Cost of Retained Earnings

• Weighted Average Cost of Capital

Problems related to Cost of Equity
Contd.
Problems related to Cost of Equity
Contd.
Problems related to Cost of Equity
Contd.
Problems related to Cost of Equity
Problems related to WACC
Problems related to WACC
Contd.
Problems related to Cost of Preference Shares
Contd.
Contd.
Contd.
 Leverage: Introduction
• In short, the term ‘leverage’ is used to describe the ability of a firm to use fixed
cost assets or funds to increase the return to its equity shareholders. In other
words, leverage is the employment of fixed assets or funds for which a firm has
to meet fixed costs or fixed rate of interest obligation—irrespective of the level
of activities attained, or the level of operating profit earned.
• Leverage occurs in varying degrees. The higher the degree of leverage, the
higher is the risk involved in meeting fixed payment obligations i.e., operating
fixed costs and cost of debt capital. But, at the same time, higher risk profile
increases the possibility of higher rate of return to the shareholders.
 Types of Leverage
1. Operating Leverage: Operating leverage refers to the use of fixed operating costs such as depreciation, insurance of assets, repairs

and maintenance, property taxes etc. in the operations of a firm. But it does not include interest on debt capital. Higher the proportion

of fixed operating cost as compared to variable cost, higher is the operating leverage, and vice versa.

2. Financial Leverage: Financial leverage is primarily concerned with the financial activities which involve raising of funds from the

sources for which a firm has to bear fixed charges such as interest expenses, loan fees etc. These sources include long-term debt (i.e.,

debentures, bonds etc.) and preference share capital.

3. Combined Leverage: Operating leverage shows the operating risk and is measured by the percentage change in EBIT due to

percentage change in sales. The financial leverage shows the financial risk and is measured by the percentage change in EPS due to

percentage change in EBIT. Both operating and financial leverages are closely concerned with ascertaining the firm’s ability to cover

fixed costs or fixed rate of interest obligation, if we combine them, the result is total leverage and the risk associated with combined

leverage is known as total risk. It measures the effect of a percentage change in sales on percentage change in EPS.
Problems related to Operating Leverage
Problems related to OL
Problems related to Financial Leverage
Problems related to Leverage
Contd.
 Capital Structure: Introduction and Concept
Capital structure is the mix of the long-term sources of funds used by a firm. It is made up of debt and
equity securities and refers to permanent financing of a firm. It is composed of long-term debt, preference share
capital and shareholders’ funds.

According to Gerestenberg, ‘capital structure of a company refers to the composition or make up of its
capitalization and it includes all long term capital resources viz., loans, reserves, shares and bonds’.

Capital Structure implies the composition of funds raised from various sources broadly classified as debt
and equity. It may be defined as the proportion of debt and equity in the total capital that will remain invested in a
business over a long period of time. Capital structure is concerned with the quantitative aspect. A decision about
the proportion among these types of securities refers to the capital structure decision of an enterprise.
 Factors influencing Capital Structure
• Size of Company: Small companies may have to rely on the founder’s money but as they grow they will be eligible for long-term financing because
larger companies are considered less risky by investors.

• Nature of Business: If your business is a monopoly you can go for debentures because your sales can give you adequate profits to pay your debts easily
or pay dividends.

• The Regularity of Earnings: A firm with large and stable incomes may incur more debt in its capital structure, unlike the one that is unstable.

• Conditions of the Money Markets: Capital markets are always changing. You don’t want to issues company shares during a bear market, you do it
when there is a bull run.

• Government policy: This is important to consider. A change in lending policy may increase your cost of borrowing.

• Cost of Floating: The cost of floating equity is much higher than that of floating debt. This may influence the finance manager to take debt financing
the cheaper option.

• Debt -Equity Ratio: As stated debt is a liability whose interest has to be paid irrespective of earnings. Equity, on the other hand, is shareholders money
and payment depend on profits being paid. High debt in the capital structure is risky and may be a problem in adverse times. However, debt is cheaper
than issuing shares. Debt interest has some tax deductions that is not the case for dividends paid to equity holders.
 Optimum Capital Structure
• An optimum capital structure has such a proportion of debt and equity
which will maximise the wealth of the firm.

• At this capital structure the market price per share is maximum and cost of
capital is minimum.

• E. F. Brigham defines—”the optimum capital structure strikes that balance

between risk and return which maximises the price of the stock and
simultaneously minimizes the firm’s overall cost of capital.”
 Features of Optimum Capital Structure
1. Simplicity:All businessmen are not educated. A complicated capital structure may not be understood by all; on the contrary it may raise
suspicions and create confusion. A capital structure must be as simple as possible.

2. Profitability: An optimum capital structure is one which maximises earning per equity share and minimizes cost of financing.

3. Solvency: In a sound capital structure, content of debt will be a reasonable proportion of the total capital employed in the business. As a
result, it has minimum risk of becoming insolvent.

4. Flexibility: The capital structure of a firm should be such that it can raise funds as when required.

5. Conservatism: The debt content in the capital structure of a firm should be within its borrowing limits. It should be free from the risk of
insolvency.

6. Control: The capital structure should be designed in a such a way that it involves minimum risk of loss of control of the firm.

7. Optimal debt-equity mix: Optimal debt-equity mix in the capital structure of a company would be that point where the weighted
average cost of capital is minimum. Optimum debt- equity proportion establishes balance between owned capital and debt capital. The firm
should be cautious about the financial risk associated with the maximum utilisation of debt.

8. Maximisation of the value of the firm: An optimum capital structure makes the value of the firm maximum.
 Capital Structure Theories
Everything you need to know about the theories of capital structure. Capital structure theories
seek to explain the relationship between capital structure decision and the market value of the firm.

There are conflicting opinions regarding whether or not capital structure decision (or leverage or
proportion of debt and equity) affects the value of the firm (or shareholder’s wealth).

There is a viewpoint that strongly supports the close relationship between capital structure
decision and value of a firm. There is an equally strong body of opinion which believes that capital
structure decision has no impact on the value of the firm.
 Contd.
1. Net Income Approach
2. Net Operating Income Approach
3. Traditional Approach
4. Modigliani and Miller Approach.
Out of these theories, Net Income approach and traditional approach strongly support the
viewpoint that there exists a relationship between capital structure of a firm and its market
value. Whereas, Net Operating Income Approach and Modigliani and Miller rule out any
relationship between capital structure and market value.
 Contd.
1. Net Income Approach: According to the Net Income (NI) Approach, as
suggested by Durand, the capital structure decision is relevant for the
valuation of the firm, In other words, a change in the financial leverage (i.e.
the ratio of debt to equity) will lead to a corresponding change in the value
of the firm as well as the overall cost of capital. According to this approach, if
the ratio of debt to equity is increased, the cost of capital will decline, while
the value of the firm as well as the market price of equity shares will
increase.
 Problems related to Net Income Approach
(a) A company’s expected operating income (EBIT) is Rs.3,00,000. It has Rs.
12,00,000, 9% debentures. The equity capitalisation rate of the company is
12%. Calculate the value of the firm and overall capitalisation rate according
to the Net Income Approach (Ignore Income Tax).
(b) If the debenture debt is increased to Rs. 15,00,000, what shall be the
value of the firm and overall capitalisation rate according to the Net Income
Approach?
(c) If the debenture debt is decreased to Rs. 10,00,000, what shall be the
value of the firm and overall capitalisation rate according to the Net Income
Approach?
Solution to the above problem
 Contd.
Hence, we can see that with an increase in the ratio of debt to equity the
value of the firm has increased and consecutively the overall cost of capital
has decreased.

Hence, we can see that with a decrease in the ratio of debt to equity the
value of the firm has decreased and consecutively the overall cost of capital
has increased.
 Net Operating Income Approach
• Another theory of capital structure, as suggested by Durand, is the Net
Operating Income (NOI) Approach. It is diametrically opposite to the net
income approach. The essence of this Approach is that the capital structure
decision of a firm is irrelevant. Any change in the capital structure of the
company does not affect the market value of the firm and the overall cost
of capital remains constant irrespective of the method of financing.
 Problems related to Net Operating Income Approach
(a) A company expects a net operating income (EBIT) of Rs. 1,50,000. Its
debts amount to Rs.8,00,000 and its cost of debt is 8%. The overall
capitalisation rate is 12%. You are required to calculate the value of the firm
and the equity capitalisation rate (cost of equity) according to the Net
Operating Income Approach.
(b) What will be the effect on the value of the firm and the equity
capitalisation rate if the debenture debt is increased to Rs. 10,00,000?
(c) What will be the effect on the value of the firm and the equity
capitalisation rate if the debenture debt is decreased to Rs. 5,00,000?
Solution to the above problem
Contd.